A lot of people are into the stock market. So why aren’t they into stocks?
Nearly half of all U.S. households now own equities, the Equity Ownership in America report reveals. But the joint study by the Securities Industry Association and the Investment Company Institute found that 85 percent of those households owned mutual funds, yet only 54 percent owned individual stocks.
Mutual funds certainly are a prudent choice for small investors, because they spread risks widely. But as your comfort with investments rises, very soon you’ll be tempted to take a more active role in your portfolio, match wits with the mutual-fund managers and try to better their returns. That means diversifying into stocks.
With some 9,000 U.S. stocks to choose from, how do you pick one? Don’t be intimidated, said Adriane Berg, author of more than 20 personal-finance books and an investment primer on the Web site iVillage.com. “It’s like dating. You’ll date a few duds, but if you date enough, you’ll find a good one.”
First, assess whether you should be in the market at all. You probably shouldn’t be in the market unless you have an “emergency” savings account that could cover your expenses for three to six months if you were unable to work. And if you are carrying credit card debt, the best investment may be to pay off that debt.
Berg suggests you put as much as you legally can in your 401(k) or other retirement plan. Then if you can save more, earmark it for the market.
Once you’ve determined how much money you’re free to invest, set your investment goals. Are you saving toward retirement, or something more imminent? “Long-term goals can wait out dips in the market,” Berg said. “With short-term goals, such as saving for a house or a vacation, you’ll need to be much more conservative.”
That may rule out most stocks, said Alyssa G. Sibley, stock analyst at financial publisher Morningstar Inc. “In short-term investing, you may be better off with fixed-income instruments such as bonds, bank certificates of deposit or money-market savings.”
Know your risk tolerance as well, said Sibley. “In today’s market, some stocks can go up 50 points one day and down 20 the next,” she said. “If you can’t sleep at night, you shouldn’t put yourself in that situation.”
How you allocate investments can insulate you against market fluctuations, Berg said. “A portfolio of 60 percent stocks and 40 percent fixed income is a lot more conservative than one with 80 percent in stocks,” she said.
Different types of stocks carry different level of risks. Preferred stocks pay fixed dividends, but stockholders do not have voting rights. When the company does well, a preferred stock’s dividend usually does not increase. But if the company fails, preferred stockholders are behind bond holders, but ahead of common stockholders, in getting back the money they invested.
Common stocks are often classified by performance. Growth stocks have fast earnings growth and do not pay dividends; profits are invested back into the company. Dot-com and other technology companies are today’s hot growth stocks. Growth stocks often are the most volatile, and therefore riskiest.
Income stocks, such as utility stocks, pay regular and large dividends. Blue-chip stocks, issued by large, well-established companies such as AT&T and IBM, usually pay regular, but small, dividends. Cyclical stocks, such as automobile stocks, are affected by economic trends. Their prices usually go down during recessions and increase in a good economy. Defensive stocks, such as food or drug stocks, usually hold their own in a recession.
“Choose stocks you can easily understand and from different industries or sectors of the economy, such as transportation, financial or manufacturing companies,” Berg said. “But only choose six to eight stocks and get to know them really well. You discover the stock has price habits, called support and resistance levels. You’ll get to know the stock the way you know a person.”
Money managers may weigh up to 200 factors when looking at a company, Berg said. They range from important factors like earnings growth to less important things such as the health of the chief executive officer.
“Put your requirements down on paper,” Berg suggested. “Maybe you want a stock that people in the company are buying, or a company that has a presence in Europe.
“It’s hard to read financial reports, but once you know a company, you realize when they’re doing well,” she said. “You know what looks normal and what’s not good. You really become on top of it.”
Sibley also suggests choosing stocks from different sectors. Her advice is to pick industry leaders within those sectors.
“It’s safer to go with one of the top players than a smaller startup company,” she said. “But look to see what the established company is doing to grow the business.”
Price/earnings, or P/E, ratio is a time-tested measure of whether a company’s stock is overvalued or undervalued but one that has adapted to modern times. The P/E ratio is the stock’s current price divided by the company’s annual earnings per share of stock. For example, if the stock’s price is $20 and its annual earnings per share is $2, the P/E ratio would be 10.
“The P/E shows the enthusiasm investors feel for the company,” Sibley said. “For instance, Cisco’s stock is selling at 100 times earnings.”
With the entire technology sector focused more on future growth, Sibley said it’s still useful to compare P/E ratios among the different tech stocks, or to compare ratios with peers within any industry group. A company’s P/E also can be tracked from year to year.
During this bull market, stock values often increase regardless of a company’s earnings expectations, another traditional measurement of a company’s performance, she said. “It’s starting to correct itself,” Sibley said. “The market is returning to fundamentals and stocks should again trade on earnings.”
Good sources to research stocks are Yahoo! Financial and the Securities and Exchange Commission’s Web site. The SEC site contains the EDGAR database, where you can look up financial information on most public companies.
Documents worth reviewing include the Form 10-K, an overview of a company’s business and financial information and the basis for its annual report, and the Form 10-Q quarterly financial statements.
An important aspect of buying stocks is knowing when to sell them. “You learn how to take a profit by taking a few,” Berg said. When the price dips again, you can buy the stock back.
Sibley says there are times you may want to sell a stock regardless of whether you have a profit. “If the stock is just down in sympathy with the market, sit tight,” she advised. “If there’s a drastic change in the fundamentals of the stock — for example revenues grow slower — if there’s a lot of consolidation within and across industries, or if there are accounting problems in the company, you probably should sell.
“Also, be familiar with what’s going on in the company and the world,” Sibley said. “Investor sentiment has a huge role in the price of a stock.”
If choosing stocks remains intimidating, Berg suggests learning the way children learn about the market. “Just do it all on paper,” she said. “Try it for a couple of months. . . . . See what would really happen. You may kick yourself because you may have made money. But you also might have lost money.”
There are several good sources of information for beginning investors on-line. Here are just a few: finance.yahoo.com, www.morningstar.com, www.sec.gov, www.investor.nasd.com and www.better-investing.org
